Yuan upside limited, but volatility may pick up

The yuan was in an upward trend from 2005 until 2013, despite a standstill during the financial crisis.

But this year, the Chinese currency no longer appears to be appreciating. In mid-November, its value against the US dollar is lower than at the end of last year.

The yuan is likely to end the year flat or slightly higher than a year earlier. The 12-month gain, if any, will be the smallest in the era after the global financial crisis.

Another change seen this year is in the fluctuation of the currency’s value. The two-way movement of the yuan has intensified.

Its sharp depreciation in February stunned the market, shattering the myth that the yuan would always rise in value.

The yuan kept appreciating for a few months before another marked depreciation in June.

After the daily trading band was widened in March, the currency’s daily volatility also increased.

The yuan’s movements this year tell us a few things.

The fact that the stable appreciation trend came to a halt this year most likely shows that policymakers were convinced the Chinese currency had reached, or come very close to, an equilibrium.

In the past three years, China’s current-account surplus accounted for less than 3 percent of its gross domestic product. The ratio could be even lower this year, since the trade surplus grew more slowly than the overall economy.

Internationally, when the ratio is lower than 4 percent, a country’s foreign exchange rate is considered balanced and reasonable. In this sense, the yuan is not undervalued.

Entering this year’s third quarter, China experienced capital outflows. It posted a deficit of US$81.6 billion in its capital and financial account for the quarter.

As capital continues to exit the country, a weaker yuan would normally be needed to reverse the outflows.

In addition, China still needs exports to increase to keep the growth rate of its economy in a reasonable range. It was net exports that bolstered GDP growth in the third quarter.

As export growth was achieved with a lower yuan, the central bank doesn’t have much room to increase the value of the currency.

Globally, the European Union and Japan kept their currencies at a low level. As China follows the principle of setting its foreign exchange rate in reference to a basket of foreign currencies, the yuan has no reason to appreciate.

Moreover, if the government decides to lower interest rates or banks’ required reserve ratio, the room to raise the value of the yuan will become even more limited.

Still, there two factors calling for a stable to stronger yuan.

First is the rising US dollar. China usually decides the value of the yuan with reference to the greenback.

Since the US has ended quantitative easing and is expected to increase interest rates sometime next year, the US dollar will return to an upward trajectory.

As the yuan has to follow the trend of the dollar to curb the outflow of speculative funds, there is pressure for it to appreciate.

The other factor is the continuing process of yuan globalization, whichdepends quite a lot on a strong yuan.

Recently, China appointed a yuan clearing bank in Canada, the first in North America. It also signed an agreement to designate such a bank in Kuala Lumpur, Malaysia.

Next week, the Shanghai-Hong Kong Stock Connect program, which will allow individual Hong Kong investors to invest with yuan in the mainland stock market, will begin.

These efforts show that globalization of the yuan is a priority for China. If users are to be attracted to the yuan, the currency must maintain its value.

As the upward and downward pressures on the yuan match each other, the most likely scenario is that its value will remain stable next year.

But short-term fluctuations may increase as policymakers try to create some volatility to punish speculators who bet on the one-way, upward movement of the yuan.

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